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General Electric Company : Lessons from a disaster

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08/27/2019 | 11:13 am
The misadventures of General Electric - once the world's largest market capitalization - are instructive for all investors, individuals and professionals alike.
A report by Harry Markopolos - an analyst specializing in the detection of accounting irregularities, whose main achievement was to uncover the Madoff fraud - published on August 15, suggests an even bigger fraud than those of Enron or Worldcom. 

While the report is sensational and interesting - Markopolos admitted that he was sponsored by a hedge fund with a large short position against General Electric - the report does highlight several disturbing elements in the accounting of the industrial American conglomerate.

First off, the disastrous acquisitions of turbine manufacturer Alstom and oil services company Baker Hughes, both overpaid and completed prematurely - on the eve of major contractions in the energy markets - have resulted in $31 billion in cumulative depreciation. 

To conceal the scale of the disaster, General Electric's management would have left some of it under the carpet, in addition to consolidating Baker Hughes in an unconventional manner, so that the impact on the cash flows would be masked, according to Markopolos. 

Secondly, the reserves necessary for the solvency of one of the conglomerate's insurance activities - the LTC segment, for "Long-Term Care" - would be underfunded by $30 billion, which the groupís management would continue to hide behind a much more aggressive accounting than that of its peers Unum, Prudential and Genworth.

This creative accounting has freed up resources - real on paper, virtual in reality - to finance significant returns of capital to the shareholders, including a massive but inept $20 billion share buyback in 2016, at a price three times higher than that of today.

In retrospect, we see that between 2012 and 2018, General Electric returned almost $106 billion to its shareholders via dividends and share buybacks, an amount nearly five times higher than its cumulative (accounting) profits over the same period.

General Electric's creative accounting has also caught the attention of the SEC - the regulator of the American stock exchange - and the Department of Justice again. This is not the first time that the groupís management has been slapped on the wrists: these repeated investigations naturally fuel suspicion.

A warning, however: it is difficult for an individual investor - or even an accomplished professional - to verify Markopolos' accusations, particularly those concerning the medical insurance activity.

As a reader, some of the allegations in the report make you smile, like the comparison of General Electric's consolidated operating margins with Madoff's annualized returns for example (what does one have to do with the other?). Or the sole reference to accounting results under GAAP, without extensive reconciliation to the cash flows, which are normally not affected by the depreciation.

Publishing a report when you have a direct financial interest in the collapse of the target's share price is of course a biased process. However, letís acknowledge that this report isnít very different in that sense from the outrageously optimistic reports published by banks when they sponsor IPOs.... 

In any case, and without saying anything about the veracity of these allegations, it is interesting to highlight five lessons we can learn from the General Electric fiasco:

First, the institutional imperative willingly requires large listed groups to report embellished results in order to please the market, because any kind of bad news would be sanctioned by a drop in the valuation, and would thus compromise refinancing efforts. On top of that, it would displease shareholders, and potentially cost managers their positions.

Secondly, the executive compensation model found in most of these large groups - made up of various performance bonuses and stock options - represents a real incentive for grey area behavior: experience shows that the temptation to exaggerate good news and silence bad news is so great that it is rarely resisted. 

Third, making a series of major acquisitions remains a perilous exercise, because the mix of different cultures, the considerable operating leverage - especially in the highly capital-intensive activities of Alstom and Baker Hughes - and volatile market conditions can derail even well-designed strategic plans in the blink of an eye. 

Four, accounting results published under GAAP or IFRS don't always have (that being an understatement) a link with the company's actual performance. See our article Accounting Profit vs. Free Cash-Flow in that regard.

Five, companies facing difficult market conditions but still maintaining - or even increasing - their returns on capital to their shareholders are asking for trouble. In France, EDF has long provided another illustrative example of this suicidal tendency to favour short-term gratification over long-term survival. 

Harry Markopolos' full report - to be taken with a grain of salt thus - is available here.

Neelie Verlinden
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